Crowding out (economics)

In economics, crowding out is argued by some economists to be a phenomenon that occurs when increased government involvement in a sector of the market economy substantially affects the remainder of the market, either on the supply or demand side of the market.

One type frequently discussed is when expansionary fiscal policy reduces investment spending by the private sector. The Government is "crowding out" investment because it is demanding more Loanable Funds and it is increasing interest rates from the borrowing, but that was broadened to multiple channels that might leave total output little changed or smaller.

Other economists use "crowding out" to refer to government providing a service or good that would otherwise be a business opportunity for private industry, and be subject only to the economic forces seen in voluntary exchange.

The idea of the crowding out effect, though not the term itself, has been discussed since at least the 18th century. Economic historian Jim Tomlinson wrote in 2010: "All major economic crises in twentieth century Britain have reignited simmering debates about the impact of public sector expansion on economic performance. From the 'Geddes Axe' after the First World War, through Keynes' attack on the 'Treasury View' in the interwar years, down to the 'monetarist' assaults on the public sector of the 1970s and 1980s, it has been alleged that public sector growth in itself, but especially if funded by state borrowing, has detrimental effects on the national economy." Much of the debate in the 1970s was based on the assumption of a fixed supply of savings within a single country, but with the global capital markets of the 21st century "...international capital mobility completely undermines a simple model of crowding out".

One channel of crowding out is a reduction in private investment that occurs because of an increase in government borrowing. If an increase in government spending and/or a decrease in tax revenues leads to a deficit that is financed by increased borrowing, then the borrowing can increase interest rates, leading to a reduction in private investment. There is some controversy in modern macroeconomics on the subject, as different schools of economic thought differ on how households and financial markets would react to more government borrowing under various circumstances.

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